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The Latvian Economy

Something is afoot in Latvia. According to the latest Eurostat data on annual wage costs, in the first quarter of 2007 wages in Latvia were up by an astonishing 32.7% when compared with the first quarter of 2006 (for a simple graph of the course of Latvian wages since 2001 try this) . Without knowing anything more about Latvia it is obvious that something important is happening here, and that the situation as it stands is clearly unsustainable.

And it isn’t only wages that seem to be spiraling out of control. Consumer price inflation has been steadily increasing, and now runs at an annual rate of around 9% (graph here), while the current account deficit (currently around 25% of GDP, chart here, graph here, also see the chart comparing Latvia with the other EU8 countries here) has also shot up, while domestic consumption is rocketing, fueled by an inward flow of bank funds and remittances (see table) and this rapid growth in domestic consumption is producing an upward spiral in house prices (see graph) – Latvia (Riga) was number one in the most recent Knight Frank global housing index at a staggering annual increase rate of 62.1% – and this spiral may well constitute a bubble.

Worse, there is some sort of consensus among experts and analysts that there may be no easy policy remedy available, that the problem may be structural, and guess what, despite all the protests from the Economist that demographic changes don’t have important visible economic impacts, the key to the Latvian problem is a demographic one: essentially they are running out of people. Running out of people that is if they wish to sustain their current high levels of economic growth and experience “catch up” growth to bring their living standards alongside those of their Western European EU neighbours. A simple example should suffice: during 2006 Latvian employment was increasing at an annual rate of around 70,000, but if we look for a moment at live births – see chart - we will see that since the early 1990s Latvia has been producing children at an annual rate of under 40,000 and that by 2006 this number is down to 21,000.

What follows below the fold are a series of observations and policy proposals which are based on a much more extensive economic analysis I carried out for Global Economy Matters, which can be found here.

Prime Minister Aigars Kalvitis, speaking in a radio interview over the weekend, appealed to Latvians to do their part in bringing down inflation and stop spending so much money. Kalvitis asked Latvians to be more thoughtful about borrowing money to buy big-ticket items, warning them that the future generation may be forced to foot the bill.

Basically the Latvian conundrum revolves around the fact that a very favourable set of economic circumstances (exceptionally high levels of global GDP growth, strong risk appetite in the banking and investment sector, EU institutional guarantees, strong inward remittances flows, and significant potential for “catch up” growth) coupled with very unfavourable internal demographic dynamics, combine to present the Latvian authorities with a rather unique problem set. As the authors of a recent BICEPS report on Latvia observe:

“The recent surges in wage growth, PPI growth and CPI growth are also worrying in the sense that they seem to indicate a shift in the economy from simply overheated to potentially structurally imbalanced.”

Essentially Latvia has a capacity problem, but this is not a problem of funds for investment, it is a labour supply one. On this virtually all the external observers who are thinking about the situation are agreed (see this recent IMF statement, and this report – Inflation in Latvia: causes, prospects and consequences – from the BICEPS group of Baltic economic analysts): the labour supply problem is the key issue.

Essentially the Latvian government seems strapped on the horns of a dilemma, and one which means they seem to be condemned to run, and keep running, in an ongoing chase to try and catch up with their own shadow (their demographic one that is). But just how big is their demographic problem?

Well the Latvian population is now falling, and at a significant rate (by 0.648% annually according to the 2007 edition of the CIA World Factbook). In addition the birth rate seems stuck at a very low level – 1.3 TFR in 2006 according to the Population Reference Bureau), and of course there is out-migration, which is hard to measure with any precision (a difficulty which is noted by both the IMF staff team and the Economist Intelligence Unit). On the latest estimate from the Bank of Latvia some 70,000 Latvians, or around 6% of the labour force, are currently working abroad – mostly in the UK and Ireland – but the true number is very likely considerably higher (IMF Selected Issues Latvia 2006, for example, puts the figure at nearer 100,000).

At the same time the internal employment situation is becoming ever tighter, with unemployment levels falling and falling – in Q3 2006, for example, employment was increasing at a rate of 7.2% (y-o-y), while the unemployment rate was down to 6.2% (falling from 8.7% a year earlier). Put another way, an increase in employment of some 75,000 produced a reduction in the unemployment rate of 2.5% (or about 30% of the registered unemployed). It doesn’t take sophisticated mathematics – or “robust” models – to see that this cannot last.

One solution is obviously to try and increase the level of labour market participation, but – and it is interesting that almost no-one here seems to be talking about the need for labour market reforms – it is hard to estimate just how much potential in reality there still is for this.

An additional problem the Latvian authorities face is the level of the wage differential with say the UK or Ireland, and the problem of out-migration that this presents. This chart, which compares the Irish and the Latvian wage distributions may be helpful in seeing the problem in better perspective.

This situation – namely one wherein a period of restrained wage growth may produce yet more out-migration which in turn makes the domestic wage pressure even greater (another kind of ‘vicious loop’) – is by no means easy to address and as the October 2006 IMF staff report authors note:

Some analysts called for expanding inward migration to alleviate shortages and dampen wage pressures. However, policymakers generally considered that this would have the effect of replacing domestic low-cost workers with imported ones, thereby holding down wages and promoting further emigration.

That is, one solution to the wage increase problem might be to open the frontiers to some extent to migrant labour, but policymakers worry that any resulting flow – being possibly mainly of unskilled workers – might only serve to push down unskilled wage rates and push more Latvian nationals over towards the UK and Ireland. Certainly the Economist Intelligence Unit in its most recent report also noted this issue (January 2007):
The government argues that rapid wage convergence with western Europe is needed to check emigration. On the latest estimate from the Bank of Latvia (BoL, the central bank), some 70,000 Latvians, or around 6% of the labour force, are currently working abroad, mostly in the UK and Ireland.

Of course there is no single clear remedy here, but I think we need to say strongly that this attempt to stem the migrant out-flow by being lax on the wage inflation front is to invite disaster, serious disaster.

Now it is important to be clear that one of the implications of the structural diagnosis that is being generally offered (both here, and at the IMF, and by the BICEPS authors) is that implementing the kind of anti-inflation plan which is being proposed will not allow Latvia to simultaneously achieve acceptable inflation, acceptable growth and a positive external balance. It would appear that Latvia has become strapped on the horns of a what is called in the literature a Tinbergen policy dilemma, simply put, and with or without the existing peg to the euro, it simply has too few instruments available with which to achieve all its policy targets. (A classic explanation of the Tinbergen dilemma from none other than euro-intellectual father Robert A Mundell – I don’t know whether to laugh or to cry at this point – can be found here, while another, and now rather outdated, version of the underlying idea – and one which became pretty fashionable in economic circles in the 1990s – is Krugman’s eternal triangle. Obviously in the light of recent developments in the global financial and migration systems this whole literature is now badly in need of an update).

So we do not live in a perfect world, indeed in the Latvian case we are living in a far from perfect one.
Migration As A Solution?

Well given that a strategy of relying exclusively on fiscal tightening and strong deflation is fraught with risk, another possibility which should be seriously considered would be to apply a determined policy mix of both decreasing the rate of economic expansion and increasing capacity by loosening labour market constraints via an open-the-doors policy towards inward migration, with the active promotion and encouragement of an inward flow of migrants from elsewhere in Eastern Europe (or further afield). This would seem sensible, and even viable given the fact that Latvia is a pretty small country. However, as Claus Vistesen notes here, this can only be thought of as an interim measure, since, as the World Bank has recently argued, all the countries in Eastern Europe and Central Asia are effectively condemned to face growing difficulties with labour supply between now and 2020 (so in this sense what is now happening in Latvia may be an extreme harbinger of the shape of things to come). But given this proviso it is clear that a short-term inward migration policy may help Latvia escape from the short-term vice it seems to be in the grip of. This short term advantage may be important, since longer term solutions like increasing the human capital component in the economy and moving up to higher value activity need much more time, and what is at issue here is transiting a fairly small economy from an unsustainable path to a sustainable one.

However Latvia certainly faces difficulties in introducing a pro-migrant policy. One of these has already been mentioned: that such an approach may ultimately put downward pressure on unskilled workers wages in a way which only sends even more of the scarce potential labour Latvia has out to Ireland or the UK. A recent report by the US Council of Economic Advisers made some of the issues involved relatively clear. The report cited research showing immigrants in the US on average have a â€œslightly positiveâ€ impact on economic growth and government finances, but at the same time conceded that unskilled immigrants might put downward pressure on the position of unskilled native workers. Now in the US cases these US workers are unlikely to emigrate, but in Latvia they may do.

Several recent surveys also suggest that the potential for outward migration remains substantial. For example, a survey conducted by SKDS (Public Opinion on Manpower Migration: Opinion Poll of Latviaâ€™s Population) in January 2006 revealed that about 22 percent of Latvian residents see themselves as being either â€œvery likelyâ€ or â€œsomewhat likelyâ€ to go to another country for work â€œin the next two yearsâ€. Based on the current estimated population, this translates into between 350 and 450 thousand residents (between 15 and 20 percent of the 2005 population). The survey also indicated that these respondents were significantly skewed toward the relatively young (15-35), which would significantly reduce the working-age population and labor force in the near future. These respondents were also slightly more likely to be male, less educated, low-income, employed in the private sector, or non-Latvian.

But there is a second issue which immediately arises in the context of projected in-migration into Latvia, and that is the situation vis-a-vis the presence of large numbers of Russophone Latvian residents who are non-citizens. The issue can be seen in the table here.

Essentially out of a total population of 2,280,000, only 1,850,000 are citizens. Of the remainder the majority (some 280,000) are Russians. And these Russians are not recent arrivals, but they are a part of a historic Russophone population which build up inside Latvia during the period that the country formed part of the Soviet Union.

The protracted way in which this problem has been resolved raises in and of itself important issues. A recent article from the Itar-Tass news agency (a Russian source I know, but still) about a joint project to settle Russian speaking Latvian residents in Kaliningrad gives some indication of how deep this problem may still be. If there is any real basis for such reports and for the idea that the Latvian authorities are still be actively considering encouraging the resettlement of Russian speaking Latvian citizens elsewhere then it may give us gives some indication of just how unprepared the collective mindset in Latvia is for all that is now about to come upon them.

Yet one more time the difference with Estonia couldn’t be clearer. According to the Baltic Times this week, Estonian Economy Minister Juhan Parts is busy working on a set of proposals – which before Parliament by November – which will attempt to address Estoniaâ€™s growing shortage of skilled workers. The quota of foreign workers will be doubled to about 1,300 and the bureaucratic paperwork slashed . Now it is true that Parts is still to bite the bullet of accepting the need for unskilled workers too, but in the present situation a start is a start (Claus Vistesen has a post on this here).

Hard landing?

Of course debating the niceties of the policies we would like to see is one thing, and addressing the economic realities of the policies we have is another. If domestic demand does not abate steadily now, a hard landing could well result. Under this kind of scenario, one or two more years of GDP growth in excess of an annual 10% rate would probably lead to such pressure on the labour market (remember the unemployment rate was dropping in 2006 by about 2.5% a year) and thus to such an acceleration in inflation that the impact on competitiveness and external liabilities would become unbearable. Under these circumstances attracting the necessary external financing would become increasingly difficult, and a sharp slowdown would probably result as the underlying accumulated output gap was corrected in an unduly short space of time. The most worrying point about such a scenario is that we really don’t know the long term consequences it might induce. Latvia – like many East European and Central Asian societies – is about to experience a severe demographic challenge, and it would be better to face that challenge with the wind behind you rather than the wind in your face, and certainly better to try and chart your own course than head off in the direction of “destination unknown”.

Incidentally, just to show how seriously I take all of this, Iand for any of you who read this and want to follow the course of events in Latvia, I have now established a Latvia Economy Watch blog, to accompany my Hungary Economy Watch one.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro.
By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

Economic diasporas can be pretty volatile. Consider Ireland, which went in a decade from being a major exporter of labor to a major importer. Young Irish of my generation went abroad in the 1980s, went to school, got first and second jobs… and then sloshed back ten or fifteen years later, as the Irish economy expanded to the point where repatriation made economic sense.

The Irish experience also suggests that a countercurrent of repatriation will begin long before the home country’s economy has reached the level of the host country’s. In fact, even when the home country is very poor, a significant number of expats will come back after a certain number of years once they’ve made enough money and can now build a house/buy a farm/get married. Rising wealth brings more back, though, and also (I believe) more skilled workers and professionals.

I suspect the details will vary greatly from country to country; Romanians will not behave like Armenians, and Latvians will be something else again. But we’re already seeing this in the wealthier countries of the EU-15. Budapest, for instance, is full of thirtysomething Hungarians who got a degree in Hamburg then worked for five years with Arthur Anderson in Berlin.

There’s also a small but growing “crossflow” between Eastern European countries. Armenia, for instance, exports workers to Russia and the Baltic states. The Romanian construction industry is full of Moldovans, Ukrainians are picking fruit in Poland.

It’s a complicated topic. But the key point is, I’d really hesitate to say that Latvia is doomed to be a net exporter of labor for many years to come.

I think it rather interesting that the Latvian prime minister had the nerve to warn the citizenry against excess borrowing because the piper will have to be paid in the future…that is extremely unusual among national leaders.

I don’t know what Riga is like, but perhaps a marketing campaign to convince young Americans that it is like Prague in the early years after the collapse of the Iron Curtain. I recall that there was a wave of Americans flocking to Prague to seek their fortunes by applying their educations.

“Itâ€™s a complicated topic. But the key point is, Iâ€™d really hesitate to say that Latvia is doomed to be a net exporter of labor for many years to come.”

But where will the immigrants come from? The other examples of migration you cited–Armenians elsewhere in the former Soviet Union, Moldovans in Romania, Ukrainians in Poland–were all predicated upon pre-existing patterns of migration and relationship which transcend the current national frontiers. If Latvia’s most likely source of immigrants is to be found in Russia and Ukraine, and if it’s politically impossible for any plausible Latvian government to promote further immigration from eastern Europe, where will the immigrants come from?

One possibility is that Latvia will have to try to develop alternative sources (Romania? Serbia? China? Vietnam?); another is that Latvia won’t promote immigration at all.

One more data point on Latvia’s domestic population prospects: according to PRB.org’s 2006 World Population Data Sheet, Latvia is experiencing 14 deaths per thousand population versus 9 births per thousand. So the country’s natural rate of population change is negative!

As the young, more skilled residents leave the country, that ratio will get even worse.

Well Hi everyone, and as usual, thanks for the interesting comments. A number of points are raised:

Ravenor

“I think it rather interesting that the Latvian prime minister had the nerve to warn the citizenry against excess borrowing because the piper will have to be paid in the future…”

Yes, I’m sure you are right in this. But I think the big point I was making is that exhortations to people not to spend are rather empty normally (normally central bankers have a more direct way to achieve this, but in the Latvian case they don’t), yet this – and trying to tighten the fiscal situation (which they aren’t doing anything like as much as the IMF are urging) – is all they are left with. The bottom line is that the anti-inflation package introduced in March doesn’t seem to treat the problem anything like seriously enough.

Hi Doug,

“Economic diasporas can be pretty volatile. Consider Ireland, which went in a decade from being a major exporter of labor to a major importer.”

Well first off, this isn’t simply about diasporas (and Turkey would be another case like the Irish one in this sense), but about demographic transitions, and about the peculiar nature of the way the transition has occured in Eastern Europe, and the specific problems this represents. Ireland and Turkey are fundamentally different from Eastern Europe in this sense.

Of course, people from Latvia *might* go back, but this is why I included the graph on the differential between Irish and Latvian wages. To stem the flow (and even attract people back) they need to close that gap. But to close that gap they need to grow, and quickly, but growing quickly is what they can’t do in a sustainable way due to the labour supply shortage. This is the vicious circle they are in.

“But weâ€™re already seeing this in the wealthier countries of the EU-15. Budapest, for instance, is full of thirtysomething Hungarians who got a degree in Hamburg then worked for five years with Arthur Anderson in Berlin.”

Yep, well please note that Latvia is just a very extreme case of a much more general problem. This, I suppose, is why it is so interesting, as it does give us some measure of what *might* happen elsewhere.

The latest Hungarian employment data are just in – I have a post on this here – and as we can see the structural tightening due to population limitations is also starting slowly to bite here, despite the evident slowdown in the US economy. As I also link in the post, similar situations to that we can see developing in Hungary are now to be seen in places as far apart as Italy, Germany and Japan.

Look. I think the problem the whole direction of your argument is following is that it simply isn’t taking on board the issue that these labour supply shortages are eventually going to become global (of course, that doesn’t mean that our the whole planet is going to come to a grinding halt, but just that our whole attitude to economic growth as we know it is likely to be forced to change.

China isn’t, IMHO, going to ever be a net exporter of people on a huge scale. Labour tightening is already slowly setting in in China (remember they are growing consistently at a rate of over 10% per annum). So Chinese migration is largely going to be an internal phenomenon, as is India’s. Bangladeshi’s of course already arrive in large numbers across Southern Indian.

The thing is, it isn’t the size of a population that matters, but its structure (Ireland is in this sense not essentially different from China).

I have put up two population examples up here to help you get the picture – Ireland 1986 to 2000, and Latvia 2006 and 2025 (these could be regarded as similar periods in the economic growth history) – and you should be able to see the clear differences between these two cases and the extraordinary difficulties that Latvia faces.

“Itâ€™s a complicated topic. But the key point is, Iâ€™d really hesitate to say that Latvia is doomed to be a net exporter of labor for many years to come.”

Obviously. They should be becoming a significant net importer. They will only become a big exporter again if this situation crashes, which it may well do. If that happens there can be an outflow of important proportions, and this may produce a situation from which, Latvia, quite simply, never recovers.

“Inward migration is not an option; the migrants would be Russians or Ukrainians, and the Latvians already have more of those than they care to have.”

This is precisely the point. This attitude needs to change, and sharpish. As I keep stressing, they are playing with fire here.

“One possibility is that Latvia will have to try to develop alternative sources (Romania? Serbia? China? Vietnam?);”

Well this would be possible, but everyone can’t be getting migrants from Vietnam (and they are below replacement fertility themselves now aren’t they?), and if you want a share of the action you really need the recruiting agency out there now. Spain, btw just open a recruitment office in Senegal. Get in quick before Africa goes too :).

“A missing piece: what are Latviaâ€™s productivity figures? Wages are obviously rising faster than productivity, but how much faster?”

Well, this really isn’t the way to put it. Wages and producer prices are rising at roughly the same rates – with a time lag of several months – as you can see from these two graphs here.

What this means is that while wages and producer prices are rising at around the 30% mark annually, aggregate productivity may be what, in the 0% to 1% range, if we are lucky. And this isn’t all, since obviously the decline in productivity (competitiveness) is very bad in the export sector, hence the deteriorating trade situation. The IMF staff team had some relevant things to say about what was happening to productivity in this environment. I’ll try and dig some comments out later.

“Itâ€™s not clear what â€œTinbergen dilemmaâ€ youâ€™re thinking of here.”

This is all explained in the BICEPS paper I linked to in the text (I reproduce some of the relevant parts below). I think it is worth the read, if you are sufficiently interested. The basic point is that, due in part to the Lat-euro peg, Latvia cannot apply effective monetary or exchange rate policy to resolve the problem, but has to rely exclusively on fiscal policy. There are thus insufficient instruments available to meet the policy constraints. That is why I am effectively suggesting adding an instrument: labour supply policy. In this way Latvia could basically begin to address the challenge without risking crashing everything.

This is an extract from the BICEPS report

In order to examine the nature of Latvian imbalances and the efficacy of the antiinflation plan it is useful to use an analytical framework of economic policy making dating back to the pioneering work of Tinbergen (1952). Tinbergen analysed the implications of the number of targets and instrument for policy making. In particular, Tinbergen showed that if there were fewer instruments than targets then it is likely that the simultaneous achievement of the desired targets will be impossible. The Tinbergen framework was further developed by Swan (1963) specifically for the purpose of macroeconomic policy analysis in an open economy with a fixed exchange rate and has been extensively used ever since. The core analytical construct is the Swan diagram.

It is generally assumed that a country would wish to achieve both internal and external balance,
where these are typically defined with respect to the particular circumstances of a given country.

Thus, in the Latvian context internal balance might be defined in terms of an inflation rate that satisfies the Maastricht criterion combined with something close to full employment or a sustainable rate of growth. External balance might be defined in terms of the sustainable medium term level of the current account. For an emerging market economy such as Latvia external balance could be consistent with a sizable current account deficit, but one that is regarded as sustainable in terms of capital flows.

On productivity, it occurs to me that the relevance of the wages/producer prices comparison might not be clear to you. As a simple rule of thumb, if there is productivity improvement then wages should be rising faster than producer prices by some noticeable amount (the productivity element). If they aren’t (on aggregate) but are rising at the same rate (which is the case) then this is prima facie evidence that there isn’t substantial productivity improvement taking place. Of course on aggregate means that some may well be getting substantial productivity improvements, but that others are losing productivity just as fast.

For “moving up the technology ladder” read moving from low productivity to high productivity sectors. There seems to be a general consensus that Latvia isn’t doing this fast enough.

This is in the last IMF staff report:

In the aftermath of the Russia crisis, Latvia successfully reoriented the destination of its exports, but failed to transform its product structure. Exports therefore remain concentrated in resource and labor-intensive goods (wood and wood products comprise 30 percent of exports), embodying inputs of low- and medium-skill blue collar workers. Among the EU8, Latvia hasâ€”by a wide marginâ€”the largest share of low-tech, laborintensive exports which compete directly with low-cost countries. In contrast to several other new EU members which are moving up the technology ladder, in recent years Latvia has seen some regression in the skill- and technology content of its exports.

In response to Douglas Muir commnets of
June 27th, 2007 at 5:02 am; I beleive it is rather short sighted to thinnk that you can remedy your skills shortage by utlising resources from a country whose own economic growth will and is huge. Why would a chinese person wish to come to latvia when their own country is doing so well? Also, ignoring the well educated Russian population you already have access to, is also extremely short sighted and a rather right wing view; by utilising the resources you already your country may benefit much sooner. Ignorence is bliss, but bliss is very short lived!

Thus, in the Latvian context internal balance might be defined in terms of an inflation rate that satisfies the Maastricht criterion combined with something close to full employment or a sustainable rate of growth. External balance might be defined in terms of the sustainable medium term level of the current account. For an emerging market economy such as Latvia external balance could be consistent with a sizable current account deficit, but one that is regarded as sustainable in terms of capital flows